Cointegration and Causality Relationship Between Stock Market, Money Market and Foreign Exchange Market in Pakistan

Abstract This paper examines the relationship between stock market (KSE-100), money market (M2 and 180 days T-bill rate), and foreign exchange market (ER: PKR/USD) in Pakistan by using monthly data covering the period from 2000:M1 to 2015:M12. The study investigates long-run equilibrium relationship between these three financial markets by employing Johansen and Juselius[1] cointegration tests. Long-run and short-run causality relationship between stock market and other macroeconomic variables is also established by employing vector error correction model (VECM) and pairwise granger causality tests. The results of multivariate cointegration test (trace test) indicate a one cointegrating vector, and the significant normalized cointegrating coefficients are evident of long run equilibrium relationship between all the selected variables. Negative and significant ECT (− 1) for all variables during full sample period witness the presence of long-run causality connection among variables, while during the military regime and democratic regime, significant difference of long-run causal connections are identified across the regimes. Moreover, the results of granger causality test also indicate that there are significant variations in the causality relationship among variables across the regimes. Therefore, it is essential for forecasting, planning and policy making to consider the importance of political governance system while analyzing the historical cointegration among financial market and make the necessary adjustments accordingly.